Introduction to Economic Analysis Chapter 7 Externalities

Chapter When the person sitting next to you lights up a cigarette , he gets nicotine and the cigarette company gets some of his money . You just suffer , with no compensation . If your neighbor house catches because he fell asleep with that cigarette burning in his hand , your house may burn to the ground . The neighbor on the other side who plays very loud music late into the before your big economics the music , and the music distributors gets his money . You out of college and wind up borrowing to buy a taxi medallion . Drunk drivers , cell phones ringing in movie theaters , loud automobiles , polluted air , and rivers polluted to the point that they catch , like Cleveland did , are all examples where a transaction between two parties harmed other people . These are external But external effects are not necessarily negative . The neighbor who plants beautiful in her yard brightens your day . Another person purchase of an electric car reduces the smog you breathe . Your neighbor investment in making his home safe from fire conveys a safety advantage to you . Indeed , even your neighbor investment in her own education may provide an advantage to may learn useful things from your neighbor . Inventions and creations , whether products or poetry , produce value for others . The creator of a poem or a mathematical theorem provides a to others . External Effects LEARNING OBJECTIVE . How can society stop people from doing annoying things and encourage them to do pleasing things ?

URL books 155 These effects are called external effects , or . An externality is any effect on people not involved in a particular transaction . Pollution is the classic example . When another person buys and smokes cigarettes , there is a transaction between the cigarette company and the smoker . But if you are sitting near the smoker , you are an affected party who is not directly compensated from the transaction , at least before taxes were imposed on cigarettes . Similarly , you pay nothing for the benefits you get from viewing your neighbor , nor is there a direct mechanism to reward your neighbor for her efforts . will generally cause competitive markets to behave inefficiently from a social perspective , absent a mechanism to involve all the affected parties . Without such a mechanism , the planter will plant too few beautiful , for she has no reason to take account of your preferences in her choices . The odious smoker will smoke too much and too close to others , and the loud neighbor will play music much too late into the night . create a market is , a situation where a competitive market does not yield the socially efficient outcome . Education is viewed as creating an important positive externality . Education generates many , including , less crime , and fewer negative of other kinds . It is widely believed that educated voters elect better politicians . Educated individuals tend to make a society wealthy , an advantage to all of society members . As a consequence , most societies subsidize education in order to promote it . A major source of arises in communicable diseases . Your vaccination not only reduces the likelihood that you will contract a disease but also makes it less likely that you will infect others with the disease . Let consider pollution as a typical example . A paper mill produces paper , and a bad smell is an unfortunate of the process . Each ton of paper produced increases the amount of bad smells produced . The paper mill incurs URL books 155

a marginal cost , associated with inputs like wood and chemicals and water . For the purposes of studying , we will refer to the paper mill costs as a private cost , the cost borne by the supplier ( in this case , the paper mill itself ) In addition , there are external costs , which are the costs borne by third parties , that arise in this case from the smell . Adding the private costs and the external costs yield the total costs for all parties , or costs . These costs , in their marginal form , are illustrated in Figure A negative externality . Figure A negative , Cost Socially Efficient Price Competitive Price Marginal Quantity In Figure A negative externality , the demand has been labeled marginal benefit , for reasons that will become apparent but it is at this point just the standard demand , the marginal value of the product . The paper mill costs have been labeled marginal private cost to the fact that these costs are only the mill costs and don include the cost of the bad smell imposed on others . The marginal social cost is obtained by adding the marginal external cost to the marginal private cost . The marginal external cost isn in URL books 157

the but the size of it is illustrated at one quantity , and it is generally the difference between marginal social cost and marginal private cost . Left to its own devices , the paper market would equate the marginal private cost and the marginal to produce the competitive quantity sold at the competitive price . Some of these of those beyond the quantity labeled Socially Efficient Quantity bad from a social perspective They cost more to society than they provide in benefits . This is because the social cost of these units includes pollution , but paper buyers have no reason to worry about pollution or even to know that it is being created in the process of manufacturing paper . The deadweight loss of these units is shown as a shaded triangle in the figure . The loss arises because the marginal social cost of the units exceeds the benefit , and the difference between the social cost and the yields the loss to society . This is a case where too much is produced because the market has no reason to account for all the costs some of the costs are borne by others . Figure External costs and I ) URL books 158

Private Marginal Cost Marginal Social Marginal Private Social Competitive Quantity Quantity Generally , a negative externality like pollution creates a marginal social cost that is higher than the marginal private cost . Similarly , a positive externality like beautification creates a higher marginal social benefit for all the marginal private ( demand ) with the difference being benefits obtained by third parties , or external benefits . These are to some extent conventions . One could have incorporated a positive externality by a reduction in the convention remains . An example of a product that produces both positive and negative is illustrated in Figure External costs and benefits . Streetlights are an example of a product that produces both Most of us like lighted streets , but they are terrible for astronomers . Similarly , large highways produce for commuters and yet harm nearby residents . The marginal private obtained by the the marginal private cost give the demand and supply of a competitive market , and hence the competitive quantity results from the intersection of these two . The marginal social benefit and the marginal social cost give the value and cost from a social perspective equating these two generates the socially URL , org books 159

outcome . This can be either greater or less than the competitive outcome depending on which externality is larger . Consider a town on a scenic bay that is with lobsters . The town members collect and eat the lobsters , and over time the size of the lobsters collected falls , until they are hardly worth searching for . This situation persists . Few large lobsters are caught , and it is barely worth one time attempting to catch them . This sort of overuse of a resource due to lack of ownership is known as the tragedy of the commons . The tragedy of the commons is a problem with a common resource shared by many this case , the lobster bay . Catching lobsters creates an externality by lowering the productivity of other lobster catchers . The externality leads to , since individuals don take into account the negative effect they have on each other , ultimately leading to a nearly useless resource and potentially driving the lobsters to extinction . As a consequence , the lobster catching is usually regulated . KEY TAKEAWAYS An externality is any effect on people not involved in a particular transaction . Pollution is the classic negative externality . will generally cause competitive markets to behave inefficiently from a social perspective . create a market is , a competitive market does not yield the socially efficient outcome . Education is viewed as creating an important positive externality . A major source of arises in communicable diseases . Your vaccination not only reduces the likelihood that you will contract a disease but also makes it less likely that you will infect others with the disease . URL books 150

Private costs are those borne by the parties to a transaction external costs are costs borne by others not party to the transaction and social costs represent the sum of private and external costs . Private benefits are those enjoyed by the parties to a transaction external benefits are those enjoyed by others not party to the transaction and social benefits represent the sum of private and external benefits . Demand is marginal private benefit supply is marginal private cost . The social optimum arises at the quantity where marginal social benefit equals marginal social cost . A different quantity than the social optimum creates a deadweight loss equal to the difference of marginal social benefit and cost . The tragedy of the commons is the overuse of a resource arising because users ignore the harmful effects of their use on other users . A child who is vaccinated against polio is more likely to contract polio ( from the vaccine ) than an unvaccinated child . Does this fact imply that programs forcing vaccination of schoolchildren are ?

Include with your answer a diagram illustrating the negative marginal benefit of vaccination , and use the horizontal axis to represent the proportion of the population vaccinated . The total production from an oil field generally depends on the rate at which the oil is pumped , with faster rates leading to lower total production but earlier production . Suppose two different producers can pump from the field . an externality diagram where the horizontal axis is the rate of production for one of the difference between the socially efficient outcome and the equilibrium outcome . Like many other states , Texas law requires that , when multiple people own land over a single oil field , the output is shared URL books 151

among the owners , with each owner obtaining a share equal to a proportion of the field under their land . This process is called . Does it solve the problem of in pumping and yield an efficient outcome ?

Why or why not ?

Imagine that many students are bothered by loud music playing at near their dorm . Using economic analysis , how would you improve the situation ?

A local community uses revenue from its property taxes to build an expressway . Explain how this could give rise to free riders and how to solve the problem . Taxes LEARNING OBJECTIVE . Can society regulate annoying behavior with taxes ?

Arthur Cecil ( proposed a solution to the problem of that has become a standard approach . This simple idea is to impose a tax on a good , thereby generating negative equal to the marginal externality at the socially efficient quantity . This is known as a tax . Thus , if at the socially efficient quantity , the marginal external cost is , then a tax would lead to the right outcome . This is illustrated in Figure The tax . The tax that is added is the difference , at the socially efficient quantity , between the marginal social cost and the marginal private cost , which equals the marginal external cost . The tax level need not equal the marginal external cost at other quantities , and the figure a marginal external cost that is growing as the quantity grows . Nevertheless , the new supply curve created by the addition of the tax intersects demand ( the marginal benefit ) at the socially URL books 152

efficient quantity . As a result , the new competitive equilibrium , taking account of the tax , is efficient . The case of a positive externality is similar . Here , a subsidy is needed to induce the efficient quantity . It is left as an exercise . Figure The tux Marginal Private Socially Marginal Cost Price I I I Marginal I I I I Socially Efficient Quantity Taxes and subsidies are fairly common instruments to control . We subsidize higher education with state universities , and the federal government provides funds for research and limited funds for the arts . Taxes on cigarettes and alcoholic beverages are used to discourage these activities , perhaps because smoking and drinking alcoholic beverages create negative . Cigarettes and alcohol also have inelastic demands , which make them good candidates for taxation since there is only a small distortion of the quantity . However , while important in some arenas , taxes and subsidies are not the most common approach to regulation of . URL , org books 153

KEY TAKEAWAYS A tax is a tax on a good , thereby generating negative equal to the marginal externality at the socially efficient quantity . Imposition of a tax leads to a competitive equilibrium , taking account of the tax , which is efficient . In the case of a positive externality , a subsidy can be used to obtain efficiency . Taxes and subsidies are fairly common instruments to control . EXERCISES . Identify the tax revenue produced by a tax in Figure The tax . What is the relationship between the tax revenue and the damage produced by the negative externality ?

Is the tax revenue sufficient to pay those damaged by the external effect an amount equal to their damage ?

Hint Is the marginal external effect increasing or decreasing ?

Identify , by using a diagram , the subsidy needed to induce the efficient quantity in the case of a positive externality . When is the subsidy expended smaller than the total external benefit ?

Use the formulae for estimating the effect of a tax on quantity to deduce the size of the tax needed to adjust for an externality when the marginal social cost is twice the marginal private cost . Quotas LEARNING OBJECTIVE . Can society regulate annoying behavior telling people what to do ?

URL books 164 The tax and subsidy approach to dealing with has several problems . First , it requires knowing the marginal value or cost of the external effect , and this may be a challenge to estimate . Second , it requires the imposition of taxes and permits the payment of subsidies , which encourages what might be politely termed as misappropriation of That is , once a government agency is permitted to tax some activities and subsidize others , there will be a tendency to tax things people in the agency don like and subsidize pet projects , using the potential for as an excuse rather than a real reason . politicians have been especially quick to see positive in oil , cattle , and the family that haven been successfully articulated . The Canadian government , in contrast , sees in filmmaking and railroads . An alternative to the tax or subsidy solution is to set a quota , which is a limit on the activity . Quotas can be maxima or minima , depending on whether the activity generates negative or positive . We set maximum levels on many pollutants rather than tax them , and ban some activities , like lead in gasoline or paint , or outright ( a quota equal to zero ) We set maximum amounts on impurities , like rat feces , in foodstuffs . We impose minimum educational attainment ( eighth grade or age 16 , whichever comes first ) minimum age to drive , and minimum amount of rest time for truck drivers and airline pilots . A large set of regulations governs electricity and plumbing , designed to promote safety , and these tend to be minimum Quotas are a much more common regulatory strategy for dealing with than taxes and subsidies . The idea behind a quota is to limit the quantity to the efficient level . If a negative externality in pollution means our society pollutes too much , then impose a limit or quantity restriction on pollution . If the positive externality of education means individuals in our society receive too little education from the social perspective , force them to go to school . URL books ( 909 165

As noted , quotas have the advantage of addressing the problem without letting the government spend more money , limiting the government ability to misuse funds . On the other hand , quotas have the problem of identifying who should get the quota quotas will often the resource . Indeed , a small number of power plants account for almost half of the sulfur dioxide ( pollution emitted into the atmosphere , primarily because these plants historically emitted a lot of pollution and their pollution level was set by their historical levels . Quotas tend to harm new entrants compared to existing and discourage the adoption of new technology . Indeed , the biggest polluters must stay with old technology in order to maintain their right to pollute . KEY TAKEAWAYS An alternative to the tax or subsidy solution is to set a quota . Quotas can be maxima or minima , depending on whether the activity generates negative or positive . Quotas are a much more common regulatory strategy for dealing with than taxes and subsidies . The goal of a quota is to limit the quantity to the efficient level . Quotas tend to harm new entrants compared to existing firms and discourage the adoption of new technology . If a quota is set to the socially efficient level , how does the value of a quota right compare to the tax ?

Speeding ( driving fast ) creates by increasing the likelihood and severity of automobile accidents , and most countries put a limit on speed but one could instead require fast drivers to buy a permit to speed . Discuss the advantages and disadvantages of speeding URL books 155

Tradable Permits and Auctions LEARNING OBJECTIVE . Is there a better way to regulate annoying behavior than either taxes or quotas ?

A solution to in the allocation of quota rights is to permit trading permits are quotas for pollution that can be exchanged to create a market in the right to pollute , and thereby create a tax on polluting . The emission of pollution requires the purchase of permits to pollute , and the price of these permits represents a tax on pollution . Thus , tradable permits represent a hybrid of a quota system and a taxation quota determines the overall quantity of pollution as in a quota system , determining the supply of pollution rights , but the purchase of pollution rights acts like a tax on pollution , a tax whose level is determined by the quota supply and demand . Figure ( prI ' 400 350 300 250 200 150 100 50 50 I I I I I I I I I I The United States has allowed the trading of permits for some pollutants , like sulfur dioxide . Figure SO shows the price of sulfur dioxide permits over URL books 157

the past decade . Each permit conveys the right to emit one ton of sulfur dioxide into the air . The overall pollution level is being reduced over time , which accounts for some of the increase in prices . These prices represent significant taxes on large polluters , as a power plant using coal with high sulfur content can annually produce as much as tons of sulfur dioxide . The major advantage of a tradable permits system is that it creates the opportunity for efficient potential polluter can buy permits from another , leaving the total amount of pollution constant . Such exchange is efficient because it uses the pollution in a manner creating the highest value , eliminating a bias toward old sources . Indeed , a polluter might sell its permits and just shut down if the price of pollution was high enough . A somewhat unexpected advantage of tradable permits has been the purchase of permits by environmental groups like the Sierra Club . Environmental groups can buy permits and then not exercise them , as a way of cleaning the air . In this case , the purchase of the permits creates a major positive externality on the rest of society , since the environmental group expends its own resources to reduce pollution of others . Tradable permits offer the advantages of a taxation use of needing to estimate the social cost of pollution directly . This is especially valuable when the strategy is to set a quantity equal to the current quantity , and then gradually reduce the quantity in order to reduce the effects of the pollution . The price of permits can be a very useful instrument in assessing the appropriate time to reduce the quantity , since high permit prices , relative to likely marginal external costs , suggest that the quantity of the quota is too low , while low prices suggest that the quantity is too large and should be reduced . URL books ( 909 168

KEY TAKEAWAYS A solution to in the allocation of quota rights is to permit trading them . Tradable permits represent a hybrid of a quota system and a taxation system . The quota determines the overall quantity of pollution , while the purchase of pollution rights acts like a tax on pollution . The United States has permitted the trading of permits for some pollutants , like sulfur dioxide . The major advantage of a tradable permits system is that it creates the opportunity for efficient exchange . A somewhat unexpected advantage of tradable permits has been the purchase of permits by environmental groups , as a way of buying cleaner air . Tradable permits offer the advantages of a taxation use of needing to estimate the social cost of pollution directly . The price of permits can be a very useful instrument in assessing the appropriate time to reduce the quantity , since high permit prices , relative to likely marginal external costs , suggest that the quantity of the quota is too low , while low prices suggest that the quantity is too large and should be reduced . Bargaining LEARNING OBJECTIVE . Can Ijust bribe my neighbor to stop being annoying ?

The negative externality of a neighbor playing loud music late at night is not ordinarily solved with a tax or with a quota but instead through an agreement . URL books 159 When there aren many individuals involved , the individuals may be able to solve the problem of without involving a government but through negotiation . This insight was developed by Nobel laureate Ronald ( and is sometimes known bargaining . offered the example of a cattle ranch next to a farm . There is a negative externality in that the cattle tend to wander over to the farm and eat the crops , rather than staying on the ranch . What happens next depends on property rights , which are the rights that come with ownership . One of three things might be efficient from a social perspective . It might be efficient to erect a fence to keep the cows away from the crops . It might be efficient to close down the farm . Finally , it might be efficient to close down the ranch , if the farm is valuable enough and if the fence costs more than the Value of the ranch . If the farmer has a right not to have his crops eaten and can the cows if they wander onto the farm , then the rancher will have an incentive to erect a fence to keep the cows away , if that is the efficient solution . If the efficient solution is to close down the ranch , then the rancher will do that , since the farmer can confiscate the cows if they go over to the farm and it isn worth building the fence by hypothesis . Finally , if the solution to the externality is to close down the farm , then the rancher will have an incentive to buy the farm in order to purchase the farm rights so that he can keep the ranch in operation . Since it is efficient to close down the farm only if the farm is worth less than the ranch , there is enough value in operating the ranch to purchase the farm at its value and still have money left over that is , there are gains from trade from selling the farm to the rancher . In all three cases , if the farmer has the property rights , then the efficient outcome is reached . Now suppose instead that the rancher has the rights and that the farmer has no recourse if the cows eat his crops . If shutting down the farm is , then the farmer has no recourse but to shut it down . Similarly , if building the URL books 170

fence is efficient , then the farmer will build the fence to protect his crops . Finally , if shutting down the ranch is efficient , the farmer will buy the ranch from the rancher in order to be able to continue to operate the more valuable farm . In all cases , the solution is reached through negotiation . argued that bargaining can generally solve problems of and that the real problem is property rights . If the rancher and the farmer can transfer their property rights , then the outcome may not arise . In the view of , if an individual owned the air , air pollution would not be a problem because the owner would charge for the use and wouldn permit an inefficient level of pollution . The case of air pollution demonstrates some of the limitations of the approach because ownership of the air , or even the more limited right to pollute into the air , would create an additional set of problems a case where the cure is likely to be worse than the disease . Bargaining to solve the problem of is often feasible when a small number of people are involved . When a large number of people are potentially involved , as with air pollution , bargaining is unlikely to be successful in addressing the problem of , and a different approach is required . KEY TAKEAWAYS When there are many individuals involved , the individuals may be able to solve the problem of without involving a government , but through negotiation . Nobel laureate Ronald argued that bargaining can generally solve problems of and that the real problem is property rights . Bargaining to solve the problem of is often feasible when a small number of people are involved . When a large number of people are URL books 171

potentially involved , as with air pollution , bargaining is unlikely to be successful in addressing the problem of . Fishing and Extinction LEARNING OBJECTIVES . Is extinction really an economic phenomenon ?

Why do we overfish ?

Consider an unregulated market like the lobster market considered previously , and let be the stock of fish . The purpose of this example is illustrative of the logic , rather than an exact accounting of the biology of fish populations , but is not unreasonable . Let be the stock of a particular species of fish . Our starting point is an environment without fishing How does the population change over time ?

Denote the change over time in the fish population by ( is notation for the derivative with respect to time , notation that dates back to Sir Isaac Newton ) We assume that population growth follows the logistic equation ( This equation two underlying assumptions . First , mating and reproduction are proportional to the stock of Second , survival is proportional to the amount of available resources , where is set to be the maximum sustainable population . Set the units of the number of fish so that is the full population . The dynamics of the number of are illustrated in Figure Fish population dynamics . On the horizontal axis is the number of fish , and on the vertical axis is the change in When , is increasing over time , and the arrows on the horizontal axis this . Similarly , if , is decreasing . Absent , the value is a stable steady state of the fish population , in which the variables stay constant and forces are balanced . It is a steady state because , if , that is , there is no change in the population . It is stable because the effect of a small near but not exactly equal URL books 172

to to return to . In fact , the fish population is very nearly globally stable . Start with any population other than zero and the population returns to . Figure Fish population ' Now we introduce a human population and turn to the economics of . Suppose that a boat costs to launch and operate and that it captures a fraction a of the total stock of fish that is , each boat catches aS . Fish sell for a price , where the price arises from the demand curve , which in this case has constant elasticity , and is the quantity of fish offered for sale . Suppose there are boats launched then the quantity of fish caught is naS . Fishers enter the market as long as are positive , which leads to zero profits for that is , This equation makes a company just indifferent to launching an additional boat because the costs and revenues are balanced . These two equations yield two equations in the two unknowns and ( and naS . These two equations solve for the number of fish caught , Unexpected text node ' and the number of boats , as . Subtracting the capture by humans from the growth in the population yields ( URL books 173

Thus , a steady state satisfies ( Figure Fish ' Will human fishing drive the fish to extinction ?

Extinction must occur when the only stable solution to the stock of is zero . Consider first the case when demand is elastic ( Then , for near zero but positive , because the other terms are small relative to the linear term . Thus , with elastic demand , there is always a steady state without extinction . Extinction is also an equilibrium , too , but won get the system there . This equilibrium is illustrated in Figure Fish population dynamics with fishing . The dark curve represents , and thus for between and the point labeled , is positive and so is increasing over time . Similarly , to the right of , is decreasing . Thus , is stable under small in the stock of fish and is an equilibrium . We see that if demand for fish is elastic , fishing will not drive the fish to extinction . Even so , fishing will reduce the stock of fish below the efficient URL books 174

level because individual fishers don take account of the externality they fishing reduces the stock for future generations . The level of in the sea converges to satisfying ( as ) In contrast , if demand is inelastic , may drive the fish to extinction . For example , if and a , and , extinction is necessary , as is illustrated Fish population dynamics extinction . Figure population ( Figure Fish population dynamics extinction shows that , for the given parameters , the net growth of the fish population is negative for every value of the stock Thus , the population of fish consistently dwindles . This is a case when the externality ( overfishing today reduces the stock of fish tomorrow ) has particularly dire consequences . The reason why the elasticity of demand matters is that , with inelastic demand , the fall in the stock of fish increases the price by a large amount ( enough so that total revenue rises ) This , in turn , increases the number of fishing boats , in spite of the fall in the catch . In contrast , with elastic demand , the number of fishing boats falls as the stock falls , reducing the proportion of fish caught , and thus preventing URL books 175

extinction . We see this for the equation for the number of fishing boats , which the fact that fishing effort rises as the stock falls if and only if demand is inelastic . It is possible , even with inelastic demand , for there to be a stable fish population . Not all parameter values lead to extinction . Using the same parameters as before , but withe , we obtain a stable outcome as illustrated in Figure Possibility of multiple equilibria . Figure ) In addition to the stable equilibrium outcome , there is an unstable steady state , which may converge either upward or downward . A feature of with inelastic demand is that there exists a region where extinction is inevitable because , when the stock is near zero , the high demand price induced by inelasticity forces sufficient to ensure extinction . As a consequence of the fishing externality , nations attempt to regulate , both by extending their own reach 200 miles into the sea and by treaties limiting fishing in the open sea . These regulatory attempts have met with only modest success at preventing overfishing . URL books 175

What is the stock of ?

This is a challenging mathematical problem , but some insight can be gleaned via a analysis . A steady state arises when . If a constant amount is removed , a steady state in the stock must occur at ( This maximum catch then occurs at and This is not the level , for it neglects the cost of boats , and the stock will actually be larger . More generally , it is never to send the population below the maximum point on the survival curve plotted in Figure Fish population dynamics . Conceptually , is an example of the tragedy of the commons externality already discussed . However , the threat of a permanent extinction and alluring possibility of solving dynamic models make it a particularly dramatic example . KEY TAKEAWAYS Extinction arises from the interaction of two systems one biological and one economic . When demand is elastic , extinction should not arise . When demand is inelastic , population decreases reduce the quantity , which increase total revenue , which leads to more investment in fishing . When demand is sufficiently inelastic , the heightened investment leads to proportionally more fish caught and the fish go extinct . Fishing is an example of the tragedy of the commons externality . Suppose . For what parameter values are fish necessarily driven to extinction ?

Can you interpret this condition to say that the demand for caught fish exceeds the production via reproduction ?

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